Editor’s Note: The following post comes to us from John J. Madden, Of Counsel and member of the Mergers & Acquisitions Group at Shearman & Sterling LLP, and is based on an article that first appeared in Directors & Boards.

When we convened our Corporate Governance Symposium last year (October 2012), we highlighted the increasingly important role shareholders were playing in the corporate decision-making process, commenting as follows:

“Over the course of the past year, we have continued to see shareholders making their voices heard, in some cases rather forcefully and effectively, on a broad range of corporate issues. In many ways, the recent developments in corporate governance reinforce the growing perception that we are, and have been for several years, experiencing a potentially fundamental shift in the balance of authority, or influence, between boards of directors and shareholders in the corporate decision-making process, moving further away from the longstanding board primacy model of corporate governance.”

One of the signal developments in 2012 was the emerging growth of the form of shareholder activism that is focused on the actual business and operations of public companies. We noted that “[o]ne of the most important trendline features of 2012 has been the increasing amount of strategic or operational activism. That is, shareholders pressuring boards not on classic governance subjects but on the actual strategic direction or management of the business of the corporation.”

In previous years, particularly following the enactment of the Sarbanes-Oxley Act in 2002 and the closely contemporaneous adoption of corporate governance rules by the national stock exchanges—both undertaken in the wake of the bursting of the TMT bubble and the uncovering of major frauds at Enron, WorldCom and other well-known public companies—much of shareholder activism was focused on structural governance reforms such as declassifying boards, redeeming poison pills and switching from plurality to majority voting in the election of directors. Active debate also developed on several board-specific issues, including the subject of combining or splitting the CEO and Chairperson roles. Executive compensation became a major governance issue and, following the 2008-2009 financial crisis, the 2010 Dodd-Frank legislation mandated, among other things, “say on pay” nonbinding shareholder votes commencing in 2011. Social responsibility topics—such as corporate political activities—also became the focus of activist attention. Many of these structural and other reform initiatives have been led by prominent pension funds as well as other investors and corporate governance organizations.

Several of these reform initiatives of the past decade continue to be actively pursued. More recently, however, the most significant development in the activism sphere has been in strategically-focused or operationally-focused activism led largely by hedge funds.

The 2013 Acceleration of “Operational” Activism

As we consider the key trends and developments in corporate governance during 2013, we see the further expansion of strategic/operational/economic activism (which we will call, for ease of reference, “operational” activism) as a prominent feature of the evolving governance landscape this year. And, in some ways it may be seen, in context, as a predictable extension of the corporate governance reforms pursued over the past decade.

Some of this operational activism in the past few years was largely short-term return focused (for example, pressing to lever up balance sheets to pay extraordinary dividends or repurchase shares), arguably at the potential risk of longer-term corporate prosperity, or simply sought to force corporate dispositions; and certainly there continues to be activism with that focus. But there has also emerged another category of activism, principally led by hedge funds, that brings a sophisticated analytical approach to critically examining corporate strategy and capital management and that has been able to attract the support of mainstream institutional investors, industry analysts and other market participants. And this growing support has now positioned these activists to make substantial investments in even the largest public companies. Notable recent examples include ValueAct’s $2.2 billion investment in Microsoft (0.8%), Third Point’s $1.4 billion investment in Sony (7%), Pershing Square’s $2 billion investment in Procter & Gamble (1%) and its $2.2 billion investment in Air Products & Chemicals (9.8%), Relational Investor’s $600 million investment in PepsiCo (under 1%), and Trian Fund Management’s investments of $1.2 billion in DuPont (2.2%) and of more than $1 billion in each of PepsiCo and Mondelez. Interestingly, these investors often embark on these initiatives to influence corporate direction and decision-making with relatively small stakes when measured against the company’s total outstanding equity—as in Microsoft, P&G, DuPont and PepsiCo, for example; as well as in Greenlight Capital’s 1.3 million share investment in Apple, Carl Icahn’s 5.4% stake in Transocean, and Elliot Management’s 4.5% stake in Hess Corp.

In many cases, these activists target companies with strong underlying businesses that they believe can be restructured or better managed to improve shareholder value. Their focus is generally on companies with underperforming share prices (often over extended periods of time) and on those where business strategies have failed to create value or where boards are seen as poor stewards of capital. [1]

Reasons for the Current Expansion of Operational Activism

There are several factors that have coalesced to help explain why this operational activism is emerging so prominently.

Evolving Attitudes of Institutional Investors. Institutional investors, which control approximately two-thirds of the common equity of public companies in the United States, have become increasingly focused on the performance of the businesses of the companies in their portfolios. In that same vein, many institutions have heightened their level of attention to their own responsibilities to the constituencies they serve. And one cannot discount the residual effects of the broad-based criticisms of boards of directors that came out of the discoveries of the major corporate frauds at the beginning of the past decade and out of the later financial crisis, as well as some investors’ continuing dissatisfaction with the rate of progress generally in reforming executive compensation.

Taken together, these developments have tended to test the level of confidence institutional investors have in the ability of some boards to act in a timely and decisive fashion to adjust corporate direction, or address challenging issues, when necessary in the highly competitive, complex and global markets in which businesses operate. And they suggest a greater willingness of investors to listen to credible external sources with new ideas that are intelligently and professionally presented.

Tangible evidence of this evolution includes the setting up by several leading institutional investors such as BlackRock, CalSTRS and T. Rowe Price of their own internal teams to assess governance practices and corporate strategies to find ways to improve corporate performance. As the head of BlackRock’s Corporate Governance and Responsible Investor team recently commented, “We can have very productive and credible conversations with managements and boards about a range of issues—governance, performance and strategy.” [2]

Increasing Activist Campaigns Generally; More Challenger Success. The increasing number of activist campaigns challenging incumbent boards—and the increasing success by challengers—creates an encouraging market environment for operational activism. According to ISS, the resurgence of contested board elections, which began in 2012, continued into the 2013 proxy season. Proxy contests to replace some or all incumbent directors went from 9 in the first half of 2009 to 19 in the first half of 2012 and 24 in the first half of 2013. And the dissident win rate has increased significantly, from 43% in 2012 to 70% in 2013. [3] Additionally, in July 2013, Citigroup reported that the number of $1 billion + activist campaigns was expected to reach over 90 for 2013, about 50% more than in 2012.

Attractive Investment Returns; Increasing Sophistication and Credibility. While this form of activism has certainly shown mixed results in recent periods (Pershing Square’s substantial losses in both J.C. Penney and Target have been among the most well-publicized examples of failed initiatives), the overall recent returns have been strong. Accordingly to Hedge Fund Research in Chicago, activist hedge funds were up 9.6% for the first half of 2013, and they returned an average of nearly 13% between 2009 and 2012. [4]

In many instances, these activists develop sophisticated and detailed business and strategic analyses—which are presented in “white papers” that are provided to boards and managements and often broadly disseminated—that enhance their credibility and help secure the support, it not of management, of other institutional shareholders.

Increasing Investment Capital Available; Greater Mainstream Institutional Support. The increasing ability of activist hedge funds to raise new money not only bolsters their firepower, but also operates to further solidify the support they garner from the mainstream institutional investor community (a principal source of their investment base). According to Hedge Fund Research, total assets under management by activist hedge funds has doubled in the past four years to $84 billion today. And through August this year their 2013 inflows reached $4.7 billion, the highest inflows since 2006. [5] Particularly noteworthy in this regard, Pershing Square’s recent $2.2 billion investment in Air Products & Chemicals was funded in part with capital raised for a standalone fund dedicated specifically to Air Products, without disclosing the target’s name to investors.

In addition to making capital available, mainstream institutions are demonstrating greater support for these activists more generally. In a particularly interesting vote earlier this year, at the May annual meeting of Timken Co., 53% of the shareholders voting supported the non-binding shareholder proposal to split the company in two, which had been submitted jointly by Relational Investors (holding a 6.9% stake) and pension fund CalSTRS (holding 0.4%). To build shareholder support for their proposal, Relational and CalSTRS reached out to investors both in person and through the internet. Relational ran a website (unlocktimken . com) including detailed presentations and supportive analyst reports. They also secured the support of ISS and Glass Lewis. Four months after the vote, in September, Timken announced that it had decided to spin off its steel-making business.

The Timken case is but one example of the leading and influential proxy advisory firms to institutional investors increasingly supporting activists. Their activist support has been particularly noticeable in the context of activists seeking board representation in nominating a minority of directors to boards.

These changes suggest a developing blurring of the lines between activists and mainstream institutions. And it may be somewhat reminiscent of the evolution of unsolicited takeovers, which were largely shunned by the established business and financial communities in the early 1980s, although once utilized by a few blue-chip companies they soon became a widely accepted acquisition technique.

Weakened Board-Controlled Defenses; Increasing Communication Among Shareholders. The largely successful efforts over the past decade by certain pension funds and other shareholder-oriented organizations to press for declassifying boards, redeeming poison pills and adopting majority voting in director elections have diminished the defenses available to boards in resisting change of control initiatives and other activist challenges. Annual board elections and the availability of “withhold” voting in the majority voting context increases director vulnerability to investor pressure.

And shareholders, particularly institutional shareholders and their representative organizations, are better organized today for taking action in particular situations. The increasing and more sophisticated forms of communication among shareholders—including through the use of social media—is part of the broader trend towards greater dialogue between mainstream institutions and their activist counterparts. [6] In his recent op-ed article in The Wall Street Journal, Carl Icahn said he would use social media to make more shareholders aware of their rights and how to protect them, writing that he had set up a Twitter account for that purpose (with over 80,000 followers so far) and that he was establishing a forum called the Shareholders Square Table to further these aims. [7]

Corporate Boards and Managements More Inclined to Engage with Activists. The several developments referenced above have together contributed to the greater willingness today of boards and managements to engage in dialogue with activists who take investments in their companies, and to try to avoid actual proxy contests.

One need only look at the recent DuPont and Microsoft situations to have a sense of this evolution toward engagement and dialogue. After Trian surfaced with its investment in DuPont, the company’s spokesperson said in August 2013: “We are aware of Trian’s investment and, as always, we routinely engage with our shareholders and welcome constructive input. We will evaluate any ideas Trian may have in the context of our ongoing initiatives to build a higher value, higher growth company for our shareholders.” Also in August, Microsoft announced its agreement with ValueAct to allow the activist to meet regularly with the company’s management and selected directors and give the activist a board seat next year; thereby avoiding a potential proxy contest for board representation by ValueAct. Soon thereafter, on September 17, Microsoft announced that it would raise its quarterly dividend by 22% and renew its $40 billion share buyback program; with the company’s CFO commenting that this reflected Microsoft’s continued commitment to returning cash to its shareholders.

What to Expect Ahead

The confluence of the factors identified above has accelerated the recent expansion of operational activism, and there is no reason in the current market environment to expect that this form of activism will abate in the near term. In fact, the likelihood is that it will continue to expand.

This, of course, will continue to place pressure on boards to regularly review corporate strategy and direction, particularly in the rapidly changing global markets in which most companies operate. We have recently seen several leading companies proactively pursuing strategic change or restructuring on their own initiatives, prior to becoming the subjects of attention by activists. In August 2013, for example, GE announced its plan to spin off its large U.S. consumer finance business, having previously also disposed of its global plastics business and its reinsurance business. And last year Pfizer announced its plan to spin off its substantial animal health business soon after it had agreed to sell its infant nutrition business to Nestlé for $11.85 billion, applying a substantial portion of the proceeds to increasing its share buyback program. We may see more companies pursuing these kinds of self-initiated restructurings going forward.

While boards need to be prepared to effectively address activism if it arises at their company, they more importantly should be thinking proactively about steps they can currently take to avoid becoming the subject of activist attention in the first place. Of course, there is no “one size fits all” approach to addressing this. But if a vulnerability assessment indicates that the company demonstrates the characteristics that attract activist attention, a strategic/operational review and assessment of alternative courses to follow would have value on several levels. And maintaining an effective ongoing communication program with the company’s major shareholders—much in the nature of relationship building—is essential.

Looking ahead, we fully expect to see continuing efforts to press for the structural governance reforms that have been pursued over the past several years. Campaigns to separate the Chair and CEO roles at selected companies will likely continue to draw attention as they did most prominently this year at JPMorgan Chase. And executive compensation will remain an important subject of investor attention, and of shareholder proposals, at many companies where there is perceived to be a lack of alignment between pay and performance. We can also expect that the further development of operational activism, and seeing how boards respond to it, will be a central feature of the governance landscape in the year ahead.

Endnotes:

[1] The web site of Trian Fund Management, for example, states that they “seek to invest in high quality but undervalued and underperforming public companies and to work constructively with the management and boards of those companies to significantly enhance value for all shareholders.”(go back)

[3]ISS Governance Weekly, September 13, 2013 (the “win rate” being the percentage of contests in which dissidents won or settled for at least part of the seats they sought). The data from Sharkrepellent for 2013 through mid-September shows similar dissident success. For that period, Sharkrepellent reports 37 contests filed and 23 going to a shareholder vote; with a dissident win rate of 65%. See Sharkrepellent, The Proxy Fight for Board Seats Trend Analysis Report, September 17, 2013.(go back)

Excellent review of the trends in shareholder activism. Activist investors have gained enormous credibiity in the court of public opinion and their methods have become part of the investing establishment.

Long forgotten is that Warren Buffett began his career as an Ackman-type activist, now he is referred to as the Sage of Omaha. Both Buffett and Ackman et. al. seek above-average returns (eg. 25% for activists vs 12% for S&P 500 in 2012) by advocating for changes in strategy, management and governance.

Investor relations officers are increasingly conducting risk-assessment and feedback studies, at the request of enlightened Boards of Directors. As retired VCs begin to populate corporate boards, they will raise the performance bar for all directors.

CEOs and executives still have too much power. It is in a way a feudal system and we need to more more to a democratic system. The system has to be designed in such a way that change is likely and possible, in contrast to the system today, where most board members are friends of the CEO and in practice there is little the board can do to influence the CEO or change it.